Paul Christian

Paul Christian

Beware the hidden tax traps!

By Paul Christian, corporate partner and head of tax at Ward Hadaway.

There are many hidden tax traps for private investors in unlisted companies. Typically a private investor ought to be considering the following areas:

  1. EIS (Enterprise Investment Scheme) or SEIS (Seed Enterprise Investment Scheme) relief, which can give income tax relief (at 30% up to £1 million for EIS and at 50% up to £100,000 for SEIS) on the investment as well as CGT (Capital Gains Tax) relief.
  2. Entrepreneurs relief or investors relief, which, if gains are not exempt under EIS or SEIS, can reduce the rate of CGT on sale from 20% to 10%.
  3. Whether to become a director, which can impact on the tax treatment of the investment.
    Any of these areas would justify a substantial article in its own right. However, rather than try and blind you with tax science, I will instead run through a number of areas where typically we see problems.

An investor is often under pressure to put money into a company to meet a deadline, such as to pay wages. That will be treated as a loan pending agreement of the detailed terms of investment. However, that money, if subsequently converted into shares or even if repaid and re-invested, will not qualify for EIS or SEIS relief as it will not be treated as new money.

Terms of Investment
There is often a conflict between the protections that an investor quite reasonably wants and the EIS/SEIS legislation which insists that the investment is proper risk capital – in other words, in tax terms, you cannot have your cake and eat it too.
It is not always straightforward as the terms of the legislation are sometimes vague and pre-clearance with HMRC is often recommended. Common areas of concern are:

  1. Anti-dilution rights. Although not specifically prohibited, HMRC appear to take the view that these are not permitted under general wording.
  2. Investors cannot have a preferred right to repayment of capital on a winding up. A trap here is that even if the investor’s shares have “normal” repayment rights, EIS/SEIS will not be available if there are other shares with subordinated repayment rights.
  3. Investors cannot have the right to acquire more than 30% of the ordinary shares or voting rights. This can cause problems around options or, for example, disenfranchising the shares of leaving employees.
  4. There are strict ‘return of value’ rules. These would prevent, for example, the payment of arrangement fees to the investor by the company. Payment by the company of the investor’s professional costs is a grey area.

Entrepreneurs Relief/ Investor Relief
A decision should be made as to whether to aim for ER or IR. IR is easier, in the sense that the 5% shareholder and voting power and employment/director tests do not have to be met, but IR requires three years’ holding rather than one year’s.

A factor for some investors may be that the £10m lifetime limits for ER and IR are exclusive – that is, even if an investor has used his/her ER lifetime limit, he/she still has a £10m IR limit available. If IR is wanted, care has to be taken not to fall into ER by accident by being a paid director.

A hidden pitfall if seeking ER in companies with shares of different nominal values, is that the 5% shareholding test is based on nominal value of shares rather than economic interest.

Directors as Employees
It is quite clear that if an investor becomes a director – even an unpaid non-executive director – the rules about taxation of employee shares or employee share options will apply to that director.

In particular, if an investor, whilst a director or in anticipation of becoming a director, receives warrants in the company, those warrants will be treated as employee share options and subject to income tax rather than CGT on exercise.

As can be seen from even this brief overview, there are plenty of tax traps for the unwary investor – all the more reason why professional advice should be taken when considering an investment in an unlisted company.

Ward Hadaway logo

Paul Christian
0191 204 4281